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It's the Advice, Stupid

When Mike DiGirolamo, former head compliance officer at Raymond James Financial, was first contacted by the NASD about how the firm determined whether fee-based or commission-based accounts were appropriate for customers, he was surprised. That feeling grew when DiGirolamo learned, mostly through the grapevine, that a dozen other firms were under review for the same reason. I think all the firms were

When Mike DiGirolamo, former head compliance officer at Raymond James Financial, was first contacted by the NASD about how the firm determined whether fee-based or commission-based accounts were appropriate for customers, he was surprised.

That feeling grew when DiGirolamo learned, mostly through the grapevine, that a dozen other firms were under review for the same reason. “I think all the firms were surprised,” says DiGirolamo, who is now head of Raymond James' investor advisory division. “It seemed like the NASD was really second-guessing the firms.”

Worse yet, as regulators requested more account documentation from Raymond James and began interviewing employees, DiGirolamo says it became clear some of the NASD examiners hadn't the slightest idea of the benefits connected with fee-based pricing, such as decreased conflicts of interest and more comprehensive financial advisory services. “They placed no value on fee-based accounts,” he explains. “They just wanted to see which way was cheaper.”

And that's exactly the wrong way to look at the issue, contends Chester Helck, president and chief operating officer of Raymond James. “It's somewhat perplexing — the NASD is supposing the value-added in fee-based accounts is about transactions,” Helck says. “It's not, it's about advice.”

For years, broker/dealers felt they had a regulatory greenlight to push the fee-based model as a better alternative to strictly commission-based pricing. The fee-based pricing model — which assesses an annual fee, often 1 percent, on the account rather than charging per transaction — was thought to better align the broker's interest with the client's. Supporters contended fee-based pricing would end the plague of churning and stop disreputable brokers from stuffing client accounts with the house's bum stocks. In addition, the client would develop a closer relationship to his broker, receiving comprehensive financial advice, investment research and hand-holding services.

The big firms like fee-based business, too, because it's a reoccurring revenue stream in that it doesn't disappear during bear markets like retail trading does (remember 2001 through 2003?). Although fee-based accounts (especially for managed accounts) are decades old, many of the big wirehouses started aggressively promoting fee-based accounts to clients during the 1990s. And as an added incentive, some b/ds offer a more generous payout on fee-based business than on transactions.

The result? The fee-based, holistic advice model is taking root: At most of the larger firms, about 20 percent to 25 percent of clients' money is in fee-based accounts, and that ratio is expected to keep growing. And some brokers are chucking their Series 7 licenses altogether, and going independent as a registered investment advisor and offering fee-only services.

No wonder the industry was shocked last November when the NASD issued a Notice to Members, none-too-gently reminding them that fee-based accounts must be appropriately used. The trouble? The NASD's definition of suitable seems to be rather simplistic: Would a client have saved money by paying per trade? Then he shouldn't be in a fee-based account.

“The notice was met with a resounding ‘Whaaat??!!’ by the industry,” says James Eccleston, a securities law specialist and partner in the Chicago law firm of Shaheen Novoselsky Staat Filipowski & Eccleston. “But we haven't heard a peep from regulators since.”

At least in terms of guidance or reassurance. But not long after that notice, NASD agents started contacting several b/ds and began looking into how some firms decided which clients would be fee-based and which would not, according to several industry players aware of the probe. In many cases, the agents would recalculate a client's annual fee payment, using both fee-based and commission-based models, then determine which one would have been cheaper for the client.

What Are Regulators Looking for?

The NASD's probe definitely has many brokers and branch managers in the industry nervous. They are unsure exactly what regulators are looking for, what constitutes a violation and what, if any, penalties could be levied. This vacuum of information has fed speculation and gossip, including one rumor that b/ds will have to offer retroactive refunds to clients. It also leaves the industry looking for guidance — either from the NASD or their own compliance units, some of which report being overwhelmed from dealing with the problem.

At least one NASD official says any confusion may be overblown. “The industry was simply put on notice as to what the NASD expects,” says Marc Menchel, executive vice president and general counsel of the NASD's regulatory policy and oversight division. “It's the normal course of events between regulators and those they regulate.” Menchel declined to comment on the scope of any NASD probe into fee-based pricing or any regulatory or enforcement actions that might result.

Many concerned brokers speculate that regulators are looking into several potential problems. First, regulators are most concerned about neglected accounts — those customers who trade very little or not at all, receive little or no advisory input, yet are kept in fee-based accounts. Brokers call this disreputable practice “reverse churning” and admit it's a growing concern. “Large firms [b/ds] want the reoccurring revenue that fee-based pricing supplies,” says the head of one California-based independent firm, adding that this pressure leads to abuses.

While few brokers would argue against ferreting out reverse churning and penalizing those brokers who practice it, some worry the NASD is going farther than that, into a second phase that examines all accounts, measuring fees assessed under both pricing models, but failing to take into account the benefits of advice and services a fee-based account provides.

Basing their speculation on how the NASD has gone through the account records at several firms, including Raymond James, industry professionals fret regulators may be requiring brokers to do a “look-back” of a customers' account activity for the past year or so, then figure out whether the customer would have been better served in a fee-based or commission-based account. If a fee-based customer is found to have paid more under that pricing model than he would have under a commission model, brokers are afraid they could be forced to provide cash refunds.

“The NASD wants brokers to be clairvoyant on how the economy is going to do and how much activity their client is going to engage in over the coming year — that's a task that's beyond most people,” says Steve McGinnis, a compliance consultant with Keystone Capital in San Diego and president of the National Association of Independent Broker/Dealers (NAIBD), which represents more than 160 b/ds nationwide. “This is casting about on the part of the NASD.”

The NASD's Menchel denies regulators want brokers to go through each account, redoing the math on thousands of transactions. “However, the broker/dealer does need a process on how it determines account suitability, and that has to be subject to oversight and periodic review,” Menchel says. What's important, he adds, is the bigger picture. “Overall, the client should be getting a pricing model appropriate to his activities and desires.”

If that's the intent, some brokers and compliance officers argue, then the NASD needs to take into consideration the value-added aspect of the services included in a fee-based account or at least give brokers more guidance about what level of activity it feels merits a fee-based account.

“If the NASD is focusing on the cost to clients rather than the benefits gained with a fee-based account, regulators are really missing the mark,” says one compliance director at a large regional firm, who asked not to be named. In lieu of such guidelines, some brokerages are making their own criteria, establishing a “rule of six,” he says. That means, if a client does fewer than six trades annually, he should not be in a fee-based account unless he's signed a waiver approving the higher fees.

Incentives From Wirehouses

What should get the NASD's attention, brokers say, is how some firms pay more for fee-based business compared to trading-based business. Critics contend the dual pay policy provides an obvious incentive for pushing clients toward fee-based accounts, which is exactly what it is meant to do. A recent report by Boston-based Cerulli Associates says regulators have been attracted to fee-based accounts because of how aggressively firms have pushed them on customers. And a large part of that aggressive promoting, the report explains, comes in the form of incentives to brokers to move customers to fee-based accounts. At Merrill Lynch, for example, brokers get a payout of 41 percent on commission-based business, but 44 percent on fee-based business [see chart on page 30]. The 3 percent differential adds up. A Merrill Lynch fee-based advisor with less than four years of experience and $200,000 in gross commissions could take home almost $20,000 more than his commission-based counterpart with the same experience and production totals, according to the Cerulli report.

A Merrill Lynch spokesman issued a statement stating, “Financial advisors choose products and services for clients based on what is most appropriate for each of their particular needs, not based on compensation. Advisors receive appropriate pay for both fee- and transaction-based relationships.”

But such incentives, and the aggressive use of them, aren't illegal; nor is there any indication that the NASD would seek to outlaw them. In fact, according to the NAIBD's McGinnis, what's infuriating for the industry is the lack of direction or guidance on exactly what is acceptable and what is out-of-bounds, not only on the incentive issue, but with fee-based accounts in general. “There's been no clear indication of parameters or guidelines from the NASD on this,” he says. “If they're unable to come up with anything, how can we?” McGinnis worries that the probe will turn into “regulation by enforcement” and firms won't learn what's expected of them until the hammer comes down.

Waiting for that hammer, Menchel of the NASD warns, would be a mistake. “Those firms waiting for enforcement actions to learn what we want are ignoring the guidance we already put out there.”

The Tully Report — Source of Confusion?

Oddly, one source of confusion is a nine-year-old report on brokerage compensation, called the Tully Report, which has been cited by the NASD. The report trumpeted fee-based accounts as a way to avoid conflicts of interest among brokers, short-circuit churning and generally align the broker's interest with that of his customer. Indeed, many b/ds point to the Tully Report's date of publication as the time when fee-based accounts, which had been around for decades, really took off.

And now, after years of embracing the fee-based pricing model, the brokerage industry is a little reluctant to loosen its grip. Already some of the largest firms have an increasingly large portion of their clients' money in fee-based accounts (see Registered Rep., April 2004); Morgan Stanley has 23 percent, Smith Barney 22.3 percent — and those totals are expected to grow across the industry as time goes on.

So what's a firm to do to keep the NASD from its door? “There's no one right answer,” says Nancy Lininger, an independent compliance professional in Camarillo, Calif. “Everything is based on a client's situation, and everyone knows, situations change.” Firms should sharpen their lookout for accounts that are inactive, and find out why, she adds. “Then at least the broker better have documentation indicating the customer is aware of and okay with the fees he's paying.”

In fact, simply forcing firms to toughen account oversight may be the main objective of the NASD's probe. “We want to make sure customers are treated appropriately when there are different pricing models,” Menchel says. “We never said one size fits all or that the cheapest is always the best.”

That may offer little relief to the clearly rattled industry. Raymond James' DiGirolamo says the NASD agents his firm dealt with were so secretive about the scope of their investigation, it left him a little uncertain as to exactly what was going on.

“They told us right out, ‘You may never hear about the results of this investigation,’” he says.

At least until enforcement actions are announced.

Creating a Bias?

Compensation incentives for fee-based business.

Firm

Payout on Commission-Based Business

Payout on Fee-Based Business

Payout Differential

Merrill Lynch*

41.0%

44.0%

3.0%

UBS Financial

33.0

37.0

4.0

Morgan Stanley

36.4

40.6

4.2

Prudential

34.0

39.0

5.0

Smith Barney

34.5

34.5

0.0

Note: Payouts are based on an assumed gross annual production of $250,000 for a veteran advisor. *Includes deferred compensation (10% of total) Source: Cerulli Associates